Regulation a European Perspective

Regulation from a European perspective Stephen Kinsella & Vincent OSullivan UL

Apologies for the Acronym Soup.

“Personal autonomy is the work of ourimagination, not the way we live. Yet wehave been thrown into a time in whicheverything is provisional. New technologiesalter our lives daily. The traditions of thepast cannot be retrieved.At the same time we have little idea ofwhat the future will bring. We are forced tolive as if we were free.The cult of choice reﬂects the fact that wemust improvise our lives. That we cannot dootherwise is a mark of our unfreedom.Choice has become a fetish; but the markof a fetish is that it is unchosen.” ––John Gray, Straw Dogs pp 109-110, emphasis my own.

Work building on• OSullivan & Kinsella, 2009, 2010, 2011, 2012.• Ourproject: describing and modelling the interactions between ﬁnancial regulation and the balance sheets of the European Union macro economy, from 1980 and 2012• Proposing alternative risk management mechanisms with respect to the Irish case, but generalizable to EU situation.

Selected workRegulatory Complexity and Uncertainty: CRD IV What caused the Irish banking crisis? UK Regulatory Reform KPV O’Sullivan and S. Kinsella (in press); Harvard Law Forum KPVO’Sullivan et al (2010); Journal of Financial Regulation and Compliance KPV O’Sullivan with PwC; Compliance Officer Bulletin Vincent’s paper on the Irish banking crisis was the PwC’s FS Regulatory Centre of Excellence wrote This paper looks at complexity and uncertainty Outstanding Paper Award Winner at the Literati the entire April 2012 edition of the Compliance associated with the Capital Requirements Officer Bulletin. Vincent wrote an article on the Directive (CRD) IV regime in Europe. It Network Awards for Excellence 2011. The paper new European financial institutional architecture – investigates current debates around giving explores the Irish banking crisis and explains how in particular the establishment of the European member states additional discretion in applying various factors contributed to a collapse in asset Supervisory Authorities and the movement further requirements than proposals, particularly prices and an economic recession. The paper towards a single rule book for financial regulation as it pertains to macroprudential supervision. It seeks to document the dangers of pro-cyclical in Europe. Vincent also wrote a piece on examines current technical standards associated monetary and government policies, particularly in macroprudential supervision and the current with own funds which have been released by the an environment of benign financial regulation and difficulties in developing models to capture the European Banking Authority and looks at the pent-up demand for credit. propagation of systemic risk. whole question of bail-in funds. Link to publication Link to publication Link to publication Is Ireland really the role model for An architecture for meta-risk regulation in Recapitalising European banks austerity? banking KPV O’Sullivan and S. Kinsella (Ed.) (2011); Financial Regulation International Stephen Kinsella (2011); Publishers: Cambridge Journal of Economics KPV O’Sullivan and S. Kinsella (Ed.) (2011); Journal of Banking Regulaton This lead article describes the EU recapitalisation Stephen’s paper describes the causes and This paper describes the EU recapitalisation consequences of Ireland’s economic crisis in the proposals which were announced as part its road proposals which were announced as part of the context of the policy solution implemented to map to stability and growth on 12 October road map to stability and growth on 12 October contain that crisis: protracted fiscal austerity. The 2011. The plans are calling for ‘significantly’ higher 2011. The plans call for ‘significantly’ higher capital paper describes the causes of the recent crisis in capital reserves to help banks replenish their reserves to help banks replenish their balance Ireland, and looks at the logic of austerity within a balance sheets to withstand market turmoil amid sheets to withstand market turmoil amid the simple model. It discusses the measures the eurozone’s sovereign debt crisis. The papers eurozone sovereign debt crisis. The papers implemented to date in the current crisis, tracing details how extra capital requirements may result details how extra capital requirements may result their effects and, asks whether Ireland is, indeed, in significant restructuring across European banks in significant restructuring across European banks the role model for fiscal austerity in the given the high costs of raising capital. given the high costs of raising capital. Eurozone. Link to publication Link to publication Link to publication Europe prepares to regulate shadow banks Supervision of banking system in Ireland What causes banking crises? KPV O’Sullivan and S. Kinsella (Ed.) (2012); Journal of Banking Regulaton KPV O’Sullivan et al (2008); Publishers: Cesifo Group S. Kinsella (in press) What causes banking crises?’ Research Int. Biz and Fin. This editorial examines global efforts to regulate Vincent’s article looks at financial supervision in the shadow banking system, in particular the Ireland and the likely knock-on impact that the US green paper released by the European subprime crisis could have on the Irish financial Commission in March 2012. It suggests that the system. It demonstrates that a benign financial financial market landscape in Europe is currently regulator allowed Irish banks to lend imprudently in flux and large swings in market activity — during the domestic property boom and are now either through financial innovation, changing heavily leveraged and expose to fluctuations in market preferences or regulatory arbitrage — property prices. The paper shows that Irish banks may unravel the work done by regulators in exposure to US subprime mortgages (either shoring up their financial systems. directly or through securitization) was minimal. Link to publication Link to publication Link to publication

Other regulatory/macro research• O’Sullivan, K.P.V. and Kennedy, T. (2008) ‘Supervision of the Irish Banking System: A Critical Perspective”, CESifo DICE Report (3), 22- 26.• Kinsella, S. (2009) ‘Financial Fragility and Corporate Governance in Ireland’, in Ronan Keane and Ailbhe O’Neal, (eds), Corporate Governance and Regulation: An Irish Perspective, Dublin: Roundhall Press, 147-170.• O’Sullivan, K.P.V. and Darragh, F. (2012) ‘A Discussion on the resilience of command and control regulation with regulatory behaviour theories,’ Journal of Governance and Regulation, 1(1), 23-45.• Kinsella, S. and O’Sullivan, K.P.V (2012) ‘Financial and Regulatory Failure: The Case of Ireland’, Journal of Banking Regulation, advance online publication, January 18, 2012.• Kinsella, S. (in press) ‘What causes banking crises?’ Research in International Business and Finance.• Kinsella, S. and O’Sullivan, K.P.V. (forthcoming) “Regulatory Complexity and Uncertainty: the Capital Requirements Directive IV”, The Harvard Law Forum on Corporate Governance and Financial Regulation.• O’Sullivan, K.P.V and Kinsella, S (2011), Recapitalising European Banks, Financial Regulation International, 14(8), 1-8 (lead article).• O’Sullivan, K.P.V. and S. Kinsella (2012) ‘2012: the year of deleveraging in Europe?, Financial Regulation International’, 15.1, pp 1-6 (lead article).• O’Sullivan, K.P.V. and S. Kinsella (2012) EC examines structural policy in banking, Financial Regulation International 15(3), pp 1-5 (lead article).• O’Sullivan, K.P.V. (2012) Concern mounts over ESMAs workload 15(3), pp 4-9.• O’Sullivan, K.P.V and Kinsella, S (2012), ‘Regulating Financial Market Infrastructures, 15(4), 1-8 (lead article).

Why is this topic important?• Pace of regulatory reform has been feverish since the ﬁnancial crisis in Europe• Higher capital requirements for banks (CRD III)• Regulating Credit Rating Agencies (CRA I, II)• Further transparency and disclosure requirements (Regulators: we need more and higher quality data!) (COREPS)• Recovery and resolution plans• New governance and internal controls requirements (remuneration)

What about regulators?• New pan-European regulators across all ﬁnancial sectors: Ø European Banking Authority (based in London) Ø European Securities and Markets Authority (based in Paris) Ø European Insurance and Occupational Pensions Authority (based in Frankfurt)• New EU macroprudential regulator, the European Systemic Risk Board• Pushtowards a ‘single rule’ book for ﬁnancial regulation across the EU to help promote the single market• New ‘intrusive’ and ‘judgements’ based supervisory philosophy (out with the ‘principles-based’, ‘risk-based’ failed regime)

Lots more to come Key RRPs: Recovery and Resolution Plans D-F: Dodd–Frank Wall Street Reform and Consumer Protection Act RDR: Retail Distribution Review COREPS: Common Reporting EMIR: European Market Infrastructure Regulation AIFMD: Alternative Investment Fund Managers Directive FICOD: Financial Conglomerates Directive CRD/R: Capital Requirements Directive/Regulation MAD/R: Markets Abuse Directive/ Regulation PRIPS: Packaged Retail Investment Products IORP: Institutions for occupational retirement provision MiFID/R: Markets in Financial Institutions Directive/Regulation CRA: Credit Rating Agencies UCITS: Undertakings for Collective Investment in Transferable Securities

A need for further research• Theregulatory agenda in Europe has lacked rigorous macroeconomic analysis (cost-beneﬁt analysis accompanying regulations is not adequate in the presence of so much institutional uncertainty, see OECD, 2012).

Practical implications• This lack of analysis could be an obstacle preventing authorities pushing forward needed reforms in the face of mounting opposition.• We are already seeing significant pull-(and push-) back from Ø regulators (who have insufficient resources) Ø firms (concerned about additional costs-particularly in raising high quality capital) Ø investors (facing lower returns on equity) Ø industrial organisations (worried about a fall-off in lending to the economy) Ø general public (frustrated by the slow pace of changes)

What is regulation?Recognition that banking is unstable, important to impose rules to constrain risky behaviorSpeciﬁcally: 1. Capital adequacy ratios (Basel I, II, III). Now Min. 8% of Risk weighted assets. Tier 1 Capital Equity capital, highly sub. Bonds Other sub. Bonds 2. Valuation issues abound. Concept of VaR during crises

Our theoretical frame• Kindleberger/Minsky/Koo (not Eggerston/Krugman), See Kinsella 2009.• Creditcreates its own reversal, essentially. Regulation is necessary to attenuate scale of the crisis.• Inthe absence of effective monetary/ﬁscal policy, regulation is the third best solution, but actually given where we are, is the most likely route to successful reform.• However, remember John Gray: regulation, like choice can become a fetish. We must be aware of its limitations.

Defining Regulation more carefullyStandard Definition: an effort exerted by an authoritative agency to change the behaviour of economic agents to a certain, pre- defined condition.Effort-some element of standard setting, information gathering and monitoring.Changing behaviour- the purpose regulation is usually to influence individual and firm-level behavioural patternsAuthoritative agency- recognises the growing importance of non- state institutions as regulators.Economic agents- reflects regulation as fundamentally a politico- economic concept which can be best understood in relation to economic or legal organisation.

Why Regulate?1. Market Failure (Public choice theories) 1. Externalities Monopoly / oligopoly 2. Information failure 3. Principal/agent problem – Information failures2. Economic Theory (Private Choice Theories): “regulation is acquired by certain interests who design and operate it for their own beneﬁt” (Stigler 19710)3. Institutional theory: Organisations create regulations and regulate new areas to establish legitimacy, expand their budgets and, ultimately, survive.

Why has regulation become important?Growth of the ‘risk society’ (Scott2000),where governments are increasingly responsible for regulating risk.Privatization of semi-state ﬁrms during the Reagan/Thatcher administrations.Propagation of the “regulatory state”, big government and the European Union (Majone 1994).Industrial and ﬁnancial failures(e.g. Collapse of Enron resulted in the Sarbanes-Oxley Act).

CoordinationBalance sheet damage Perfect Complexity storm Fiscal constraints Contagion

Current Balance Sheet View:

Macroeconomics: Its all b/s Taylor, 2010, pg. 135

Macroeconomics: Its all b/sHouseholds Firms Government Central BankAssets Liabilities Assets Liabilities Assets Liabilities Assets LiabilitiesMoney Mortgages Capital Loans “Faith & Bonds Bonds BankBonds Net Bonds Credit” Reserves ReservesEquity Worth Equity (Int’l)Housing Net WorthCommercial Banks SPVs Leveraged Finance Rest of WorldAssets Liabilities Assets Liabilities Assets Liabilities Assets LiabilitiesLoans Money Mortgages CDOs CDOs Loans Int’lMortgages Equity NAMA’d Repos Repos ReservesBank stuff Equity (netReserves worth Taylor, 2010, pg. 135

Fiscal Issues

Imbalances

Concentration & Complexity are features of modern banking.P. Gai, A. Haldane, S. Kapadia, Complexity, Concentration and Contagion, Journal ofMonetary Economics 58(2), 2011

Concentration & Complexity are features of modern banking. • Coordination as patchwork recognized back in1996 as a potential disaster wrt regulatory arbitrage. • Supervisory authorities on top of national regulators include AFME, AIMA, EACH, EBF, FOA, ICMA & ISDA. • One rule book approach still developing • No solution to ‘ﬁnancial innovation’ just yet.See Adrienne Heritor The accommodation of diversity in European policy-making and its outcomes:Regulatory policy as a patchwork, Journal of European Public PolicyVolume 3, Issue 2, 1996.

Concentration & Complexity are features of modern banking. • Complexity of rules ensure heterogenous implementation & are inimical to coordination.Andrew Haldane, Executive Director, Financial Stability, Bank of England, Capital Discipline, speech at the American Economic Association,Denver (Jan. 9, 2011) at http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

Haldane, 2011: “As a thought experiment, imagine instead we were designing a regulatory framework from scratch. Finance is a classic complex, adaptive system. What properties would a complex, adaptive system such as ﬁnance ideally exhibit to best insure about future crises? Simplicity is one. There is a key lesson, here, from the literature on complex systems. Faced with complexity, the temptation is to seek complex control devices. In fact, complex systems typically call for simple control rules. To do otherwise simply compounds system complexity with control complexity.”Andrew Haldane, Executive Director, Financial Stability, Bank of England, Capital Discipline, speech at the American Economic Association,Denver (Jan. 9, 2011) at http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

Example• ESMA’s regulation of Credit Rating Agencies required the following:• ESMA, Consultation Paper - Regulatory Technical Standards on the Information to Be Provided to ESMA by a Credit Rating Agency in its Application for Registration and Certiﬁcation and for the Assessment of its Systemic Importance, ESMA/2011/302 (Sep. 19, 2011); ESMA, Consultation Paper - Regulatory Technical Standards on the Assessment of Compliance of Credit Rating Methodologies with the Requirements Set out in Article 8(3) of Regulation (EC) No 1060/2009, ESMA/2011/303 (Sep. 19, 2011); ESMA, Consultation Paper - ESMA’s Draft Regulatory Technical Standards on the Presentation of the Information That Credit Rating Agencies Shall Disclose in Accordance with Article 11(2) and Point 1 of Part II of Section E of Annex I to Regulation (EC) No 1060/2, ESMA/2011/304 (Sep. 19, 2011); ESMA, Consultation Paper - ESMA’s Draft Regulatory Technical Standards on the Content and Format of Ratings Data Periodic Reporting to Be Submitted from Credit Rating Agencies, ESMA/2011/305 (Sep. 19, 2011)

Historical context• Allof this has happened before. It will happen again. Regulation is not the solution to attenuating the Minsky cycle, but part of it.

Schularick, Jorda, and Taylor, 2011

Digression on the Irish Crisis

All of the preceding datataken from regulator/CBI

“History repeats itself…• ….. in financial matters because of a kind of sophisticated stupidity.”• “Financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind.”• “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable form.”• “It [the collapse of 1837] introduced a distinctly modern attitude toward the loans that were outstanding...Anger was expressed that Galbraith 1993 foreign banks and investors should now, in hard times, ask for payment of debts so foolishly granted and incurred. A point must be repeated: only the pathological weakness of the financial memory...allows us to believe that the modern experience of Third World debt...is in any way a new phenomenon.”

Banking crises hits growthSource: Richmond Fed, Nov 2011

Not that different from the past Distance in years from ﬁrst year of crisisSource: Citi Investment research Dec 2011 & IMF. * shortfall is compared to average for countries with systemic banking crises, 1980 – 2011)

ECB: carry that load Source: ECB

Flow of funds in the eurozone Households Financial corporations Rest of World Households Source: ECB, ICFR calculations

See Handout. Deleverage? Credit growth/ decayDeleveraging the Eurozone. VoxEU, 17 December 2011. (WithKPV O’Sullivan)

Current Challenges• Crisis is evolving, todays solution is not tomorrows.• Low high-quality information environment.• Banks are not passive actors, regulation does not help them.• Balance is not something to strive for in this space.

Our ‘SADLIR’ Financial Regulatory Cycle

New Issue(s)• How long can monetary and ﬁscal policy support banks?• Raising capital• Proﬁtability• Shadow banking. Huge issue, see O’Sullivan & Kinsella (2012)• Macroprudential supervision: who, how and why?• What about ‘good regulation’ principles? Are there any?

Core tier 1 capital of G-SIFIs 9% target set by the EU Leaders by July 2012*= Global systemically important ﬁnancial institutions as per IMFs (Nov. 2011) list: http://www.ﬁnancialstabilityboard.org/publications/r_111104bb.pdf, excluding Banque Populaire which is not listed. Data sourced from Thomson Reuters.

Loan assets of ﬁnancial Base Jan2008=100 institutions

Deleveraging starting to bite in Europe (net % of banks contributing to tighter lending standards, euro area) Source: ECB bank lending survey January 2012, q1 2010-q4 21011

The Future?Meta-risk regulation: Trades off Micro vs Macro stability.Three Mile Island crisis in 1979.Move from just inspecting compliance of rules to evaluating risk management systems.Seeking to establish if senior managers have the “risk analysis intelligence” to deal with unforeseen events.Regulator needs to establish institutional structures to support a more towards MMRConnecting MMR into a macroeconomic framework is the next step

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Regulation a European Perspective

by Stephen Kinsella

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